Are Strong Sales From PlayStation 4 and Xbox One Enough to Offset Gaming's Declining Software Market?

The most recent gaming consoles debuted with a bang. While the Sony (NYSE: SNE) PlayStation 4 is favored to beat Microsoft's (NASDAQ: MSFT) Xbox One in the quest for market leadership, both consoles are outperforming their predecessors by healthy margins. The PS4 had sold more than 7 million units to consumers as of April 6, while Microsoft has shipped more than 5 million Xbox One units to retailers--enough to make it the company's fastest-selling console ever. These admittedly great sales don't provide the whole picture, however.

Buried amid the joyous news of record-breaking hardware sales are a series of indicators that suggest a more ominous future for the gaming industry. Moving hardware at a record clip is great, but the market really revolves around software sales, and things aren't looking so good on that front. Can the success of new consoles from Sony and Microsoft reverse the worrying software trends and preserve the console gaming industry?

PS4 and Xbox One sales push industry to small growthAccording to data from retails sales tracker NPD Group, physical gaming spend in March grew 3% when compared to the period in the previous year. This growth is almost entirely attributable to strong sales of the PlayStation 4 and the Xbox One, which sold approximately 370,000 units and 311,000 units, respectively. Hardware sales were up 78% over March 2013, indicating that the last batch of console hardware had overstayed its welcome and that there is strong demand for the new consoles. Retail software sales for the month, however, were down 27% when compared to the previous year.

A huge month for new releases returns a huge software declineWith hardware sales at such a high level, it makes sense that there is less available in the consumer spend pool to dedicate to software, but this worrying trend kicked off way before the PS4 and Xbox One debuted last November and it seems unlikely that software will return to previous heights.

This past March was a huge month for gaming releases, but a slew of high-profile releases wasn't enough to stop the precipitous drop-off that occurred. The month saw the release of Titanfall from Electronic Arts, Sony's Infamous: Second Son, South Park: The Stick of Truth from Ubisoft, Dark Souls II from Namco Bandai, and Metal Gear Solid V: Ground Zeroes from Konami, but sales of new games plummeted 42% compared to the corresponding period in 2013.

Source: Xbox.com

Can digital sales offset retail decline?The rise of digital sales offsets some of the precipitous decline that is currently under way in retail, but not enough. 2013 saw total videogame spend (including digital sales) decline 2% compared to the number from 2012, a year that saw combined revenues drop approximately 9% compared to those from 2011. These worrying figures explain why publishers are focusing their efforts on a smaller number of increasingly expensive triple-A games that are capable of generating ongoing revenue through mircotransactions and downloadable content expansions.

The new software landscapePlayStation 4 and Xbox One are pushing impressive numbers at this point in their respective lifecycles, but nowhere near enough to suggest their combined user base will exceed what was available in the previous generation. The complete failure of Nintendo's Wii U in comparison to last generation's Wii guarantees that total dedicated hardware sales will see a contraction. This fact necessitates that big games branch out on PC, mobile, and set-top box platforms in addition to featuring greater emphasis on microtransactional revenue streams. Platform holders like Sony and Microsoft will receive fewer software royalty payments and increasingly rely on revenues generated from their online services.

In an interview with Edge, Epic Games founder Tim Sweeney stated that the current hardware generation will see about a third as many triple-A games. Epic is the developer of last generation's highly successful Gears of War trilogy, the upcoming PC Free-to-Play game Fortnite, and the industry-defining Unreal engines. According to Sweeney, the new cycle of triple-A games will carry budgets that are effectively three times the size of the previous generation's big software projects.

Source: Fortnite.com

What does this mean for GameStop?The new reality of gaming's software landscape is incredibly troubling for GameStop (NYSE: GME) . The company has already announced that it will be increasingly focused on the sale of smartphones and mobile devices, but this move will not come close to offsetting the threats facing its game sales and trade-in model. Software margins (particularly on the trade-in side) are GameStop's lifeblood. Recent blows to the net neutrality movement will create obstacles for games streaming services and online content stores and give the retailer some much needed breathing room, but apocalyptic changes are under way.

The gaming industry is changing...Gaming has never been more mainstream, so it's not as if the broader industry is in jeopardy. More accurately, the parties that once dominated the game must now adapt to shifting playing field. Companies like Amazon, Apple, and Google are rushing to improve their gaming offerings and continue the push to make interactive entertainment ubiquitous. Sony and Microsoft can still find success with their efforts, but what success looks like and the path to achieving it are in flux.

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